By Michael Witts, Head of Treasury, ING DIRECT
The economic environment has changed significantly over the past few months.
The election results in both Greece and France have further heightened the sovereign debt crisis in Europe. The failure to achieve a working government in Greece means that new elections will be held in mid-June, this will serve to further drag out the current uncertainty.
The second election in Greece is being seen as a referendum on support for the austerity programs and, in effect, continued membership of the EUR.
The prospect of the exit of Greece from the EUR has increased against this backdrop. However, the reality is that Greece and, as a result, Europe cannot afford for Greece to exit the Europe.
While the Greek electorate may be voting against a known future of quantified austerity measures, exiting the EUR would result in voters facing an extended period of deep economic recession with a particularly uncertain future. Social unrest would immediately follow.
Spain is the latest European country in intensive care. The banking system is under severe pressure as the combined impact of mounting bad debts, largely through property loans, and deposit outflows take their toll. The Government’s budget position does not provide scope for it to effectively rescue the banking system. Therefore, in all likelihood Spain will require international assistance accompanied by further austerity measures.
The recent G8 meeting expressed very strong support for Greece remaining in the EUR. Despite the current political posturing, it appears likely Greece will remain in the EUR, although the ongoing uncertainty will contribute to market volatility.
Elsewhere across the globe, concerns have emerged about growth in China and the potential impact on commodity prices.
Recent forecast suggest China’s economy will grow by around 7-8% over the year ahead. Although slower than recent years, the slower pace has been the result of deliberate policy action by the Chinese government.
The challenge for the Chinese economy is to engender domestic growth in the face of a weakening global environment. In response to the weakening environment, monetary policy in China has been eased to facilitate this repositioning.
Despite the short term pessimism regarding Chinese growth, the more likely scenario is that the pipeline of infrastructure projects currently underway and, in prospect, in China will provide a solid foundation for the future. In turn, this will underpin demand for commodity exports from Australia.
US growth continues to improve with the recovery becoming more broad based. Reflecting the comparatively insular nature of the US economy, it is largely immune from event in Europe.
Clearly, European volatility will dominate markets for the period ahead. On balance, we believe that stability will emerge over the northern summer as the election uncertainty in Greece recedes and their commitment to EUR and austerity measures is reaffirmed despite protests.
Domestic Economic Considerations
The benign inflation result for the March quarter, together with the slowdown in domestic credit growth in both the household and business sectors in recent quarters, paved the way for the Reserve Bank to cut the cash rate at its May meeting by 50 basis points.
While the market had anticipated the easier tone from the RBA, expectations were focussed on a more gradual trajectory.
Housing mortgage interest rates were subsequently reduced by around 30/40 basis point, as banks sought to recover margin eroded through higher funding costs.
The surprise move by the RBA saw the AUD come under selling pressure.
Subsequent events in Europe, revisions to the global growth outlook and weaker commodity prices have seen further weakness in the currency. The AUD is currently around .97, slightly above an 8 month low.
The response in interest rate markets has been to sharply increase expectations of further significant interest rate cuts in the period ahead.
At its June meeting the Reserve Bank reduced the cash rate by 25bps to 3.50%.
The Bank cited the need to insulate the economy from international events as the main driver behind the decision. The Bank noted the deterioration in financial market sentiment over the past month and that households and businesses continue to exhibit precautionary behaviour.
Previously the Bank had commented that, due to the positive inflation outlook, it had significant scope to further adjust policy in the event global and or domestic factors warranted such a response.
Currently, the futures market suggests that the 90 day bill rate will reach a low of around 2.75%, compared with the current rate of 3.4%. This compares with 4.05% at the end of April.
In the absence of a major deterioration of events in Europe this would appear to be overdone.
Despite all the noise, the fundamentals for the Australian economy remain very positive, although uneven. The dichotomy in the economy is an inevitable outcome from the strong growth in the resources sector, diverting resources and exposing other sectors of the economy to the impact of the higher exchange rate.
Implications for Borrowers and Investors
Reflecting the very strong expectations of sharp cuts in official interest rates, market interest rates are at record lows across the yield curve.
This provides great opportunities for borrowers to lock in the current low fixed rates. From a budgeting viewpoint, it is a good idea to have around 50/75% of a mortgage on a fixed rate basis for a term of say 3 years. This provides a high degree of certainty in relation to monthly repayments. The remainder of mortgage remains at the variable rate, such that if these rates move lower, the client enjoys some of the benefit. Equally, if variable rates increase the client is well protected.
Given the historically low level of absolute rates, this appears to be the prime time to look closely at locking in fixed rates.
From an investor viewpoint, while absolute rates have moved sharply lower the intense competition for term deposits has cushioned the decrease in rates. In this environment, investors are taking advantage of floating rate debt instruments. The benefit of these products is that it locks in the current wide credit spreads without locking in the low absolute rates.
As floating rates start to increase over time, the return to the investor is further enhanced, in addition to the current wide credit spreads. Hence, the absolute return to the investor increases.
5 June 201